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Due diligence and worker classification: How independent contractors can change the value of a deal

When should workers be classified as independent contractors? If you don’t know, you could face significant problems in an acquisition.

The classification of workers as employees or independent contractors has long been a contentious issue between the IRS and businesses. Many businesses prefer to classify workers as contractors since contractors are often not covered by company retirement or fringe benefit plans. However, the IRS has often challenged these classifications since payments to employees are subject to payroll tax withholding and matching employer contributions of FICA and Medicare taxes. Independent contractors, on the other hand, pay self-employment tax.

An unresolved worker classification issue should cause significant concern in any deal for two reasons. First, if independent contractors are reclassified as employees, the post-deal entity could face successor liability for a host of payroll taxes, including employer contributions for FICA and Medicare as well as federal and state unemployment taxes. This exposure can often be more significant than income tax matters since it’s not limited by the profitability of the business and it’s a permanent item that doesn’t reverse from year to year. Second, the value of the business might be impacted by the reclassification of workers as employees since significant EBITDA adjustments might result from additional payroll tax and benefit expense.

When workers should be classified as employees

The determination whether a worker is a contractor or employee is made on a facts and circumstances basis, and no single factor is determinative. However, the factors used by the IRS generally fall in to three main categories that haven’t changed much over the years — it comes down to the amount of behavioral and financial control a business exercises over the worker and the relationship of the parties.

The problem is each new decision is based on individual facts and circumstances. As a result, the application of the rules is somewhat uncertain since the courts have looked to a number of different facts when deciding cases. Each new ruling provides some insight into what tipped the scale toward employee or independent contractor, but it’s almost impossible to be certain about your business’s circumstances until the IRS or a court rules on them.

If your due diligence suggests that a reclassification is likely, you’ll need to make sure the deal is structured to account for it.

What to look for

For due diligence purposes, an acquiring company needs to know if the target uses or has recently used independent contractors. Certain industries rely heavily on independent contractors for the workforce. In other cases, only some functions of a business might typically be outsourced to a contractor. Some common jobs for independent contractors include:

Sales representatives.

HR service providers.

Construction contractors.

When a business uses independent contractors, it’s required to report what it pays them to the IRS. One indicator of independent contractor use would be the Form 1099 that a business uses to report that information.

Once you know the target employs contractors, you’ll want to evaluate the relationship in the same manner as the IRS. The Service evaluates the relationship based on the facts and circumstances of each business. The examiner will look at the overall relationship of the parties and focus specifically on the behavioral control and financial control the business exercises over the contractor. The determination to reclassify can be based on any number of factors, and it can be difficult to predict what conditions might result in this.

What to do

If you’re working on an acquisition and you learn that the target has relied heavily on independent contractors, you should have that classification reviewed by someone familiar with the rules to determine the risk of a reclassification.

If your due diligence suggests that a reclassification is likely, you’ll need to make sure the deal is structured to account for it. Buyers can include clauses in their transaction documents to mitigate the impact of a reclassification if one occurs, such as:

Adjusting the transaction price to reflect the potential impact of future payroll taxes and benefits on EBITDA.

Expressly agreeing in advance which party is liable for any adjustment.

Holding additional amounts in escrow for an extended period of time to pay the costs of a future reclassification.

An example — Uber

Perhaps the most prominent case right now involves Uber drivers. In this class action law suit, Uber workers are asserting that they are employees, rather than contractors, to procure certain benefits. If the employees are successful and the IRS classified the workers consistently with the law suit, Uber could face significant liabilities for unpaid payroll taxes and penalties. Since Uber enlists approximately 400,000 drivers in the United States, the additional benefit costs and payroll tax expense could have a substantial, unfavorable impact on its value.

In conclusion

When considering deals, buyers should consider whether there is exposure associated with the reclassification of workers. If so, they should consider quantifying the exposure during due diligence and structuring the transaction to protect themselves.